Saturday, November 30, 2019

Corporate Formalities for Delaware Startups

You have just formed your very first Delaware corporation. Congratulations! Although as a busy founder you may not have time to take care of ongoing corporate maintenance, there are some minimum corporate formalities that you should strive to maintain.  Below is my list and the reasons why.

One of the main benefits that is afforded by corporate structure is the limited liability protection for its owners. This means that the corporation and its stockholders are treated as separate legal entities. The corporation enters into its own contracts, and therefore, it is only the corporation’s assets, and not the assets of its individual stockholders, that are available to pay for judgments and claims of creditors.

There are, however, circumstances when a creditor of a corporation can “pierce the corporate veil” to hold the corporation’s stockholders liable for the corporation’s debts and other obligations. When deciding whether to pierce the corporate veil and hold stockholders personally liable, courts consider, among other factors, whether:
  • the corporate formalities have been disregarded;
  • the corporation is a mere fa├žade of its owners; 
  • the corporation is inadequately capitalized; 
  • the owners use the corporation’s assets and property as their own; 
  • the corporation makes undocumented “loans” to the owners or extends credit not on market terms; or 
  • the owners simply take money out of the corporation; 
The following best practices with respect to corporate governance and external appearance of the corporation may strengthen the argument that the corporation exists as a separate legal entity:

Stockholder and Board of Directors Meetings. The corporation should hold both annual stockholder and Board meetings (or at least prepare unanimous written consents). In addition, the Board should consider and approve all significant actions of the corporation (such as taking out loans, hiring executive officers, selling securities, entering into any other transaction that is out of the ordinary for such corporation). A majority of disinterested directors or the stockholders should approve all transactions between directors, officers, and the corporation.

Delaware Annual Report and Franchise Tax. In order to maintain good standing in Delaware, the corporation has to file an online annual report with the Delaware Division of Corporations and pay the Delaware franchise tax no later than March 1st of each year.

Delaware Registered Agent. It is important to renew the services of the mandatory Delaware Registered Agent every year.  The fee is about $50/year.

Qualifying to Do Business in the Other States. If the corporation is conducting business in another state, it must register there as a foreign corporation and pay tax on the income derived from that state. The definition of “conducting business” varies state by state. So, please reach out to your accountant or lawyer for assistance with this question.

Separate Bank Account. The corporation must have its own corporate bank account. All expenses must be paid from that account and all revenue be deposited there. If the founders paid for incorporation expenses personally, they should submit an expense report and be reimbursed by the corporation from the corporate bank account. One of the “red flags” for the “piercing of the corporate veil” argument is the co-mingling of funds between the corporation and its owners.

Hiring Employees. The hiring process is complicated and involves setting up payroll, preparing pay notices, registering with appropriate state authorities, complying with federal immigration laws, and obtaining the mandatory insurance policies. Failure to comply with these requirements may result in hefty fines.

Debt Guarantees. Stockholders should be careful not to personally guarantee and pay debts of the corporation (at least not on the recurrent basis). Otherwise, the courts may decide that the owners act as “alter egos” of the corporation and the corporation has lost its separate entity status. Board resolutions should be adopted allowing guarantees for specified purposes only.

Acting on Behalf of the Corporation. All documents signed on behalf of the corporation must indicate the signing officer’s name and title. For example:

XYZ Inc.

Name: John Smith
Title: CEO

Further, all contracts should be in the name of the corporation, and the insurance policies should name the corporation as the insured. The full corporate name should appear on the website, business cards, letterhead, and checks of the corporation. 

In conclusion, although this list seems long, it actually doesn't take much effort to comply with if the proper procedures have already been set up.  Your accounting and legal team should work with you on ensuring that your startup follows all corporate formalities.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Thursday, August 22, 2019

SEC Complaint Against a VC Exempt Reporting Adviser

On August 13, 2019, the SEC filed a complaint against Stuart Frost and Frost Management Company, LLC for violating the antifraud provisions of Sections 206(1)-(2) and 206(4) of the Investment Advisers Act.  This case is a reminder that certain provisions of the Advisers Act apply to all investment fund managers, regardless of whether they are registered, non-registered, or exempt (exempt reporting advisers are referred to as "ERAs").  Also, this case highlights once more the importance of proper disclosure of management fees and expenses (and that they have to be reasonable and market).

Mr. Frost, through his investment management firm, managed five venture capital funds that raised about $63 million.  These funds were invested into start-ups incubated by Frost Data Capital, LLC ("FDC"), an entity wholly-owned by Mr. Frost.  Start-ups paid incubator fees to FDC.  The SEC complaint alleges that these incubator fees were not properly disclosed to the investors and, in fact, were exorbitant.  As stated in the SEC press release, the fees were used to finance Mr. Frost's "extravagant personal expenses" and "lavish lifestyle", and when he ran out of money, he would create and fund new start-ups in order to obtain more incubator fees.

Section 206 of the Advisers Act Applies to All Fund Managers

The anti-fraud provisions of the Advisers Act apply to ALL investment advisers, regardless of their status with the SEC or state authorities, or the absence thereof. In particular, Section 206 of the Advisers Act states:

"It shall be unlawful for any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; ...

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."

Further, all investment advisers owe a fiduciary duty to their clients of undivided loyalty and may not engage in any activity that conflicts with the interests of their clients without their prior consent.  As held by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the advisers owe to their clients a duty of good faith and full and fair disclosure of all material facts and a duty to avoid misleading them.

According to the complaint, FDC (wholly-owned by Mr. Frost) was financially dependent on the incubator fees paid by portfolio companies.  FDC charged the portfolio companies $21.69 million in incubator fees.  None of that money went to the investors.  In the fund disclosure materials, Frost and his management company either completely omitted the existence of such incubator fees or misled the investors by saying that FDC would charge incubator fees on a case-by-case basis and at below-market rates.  In reality, every portfolio company was charged with such fees, which were $30,000 - $40,000 per month per portfolio company.  The fees had to be paid even if the portfolio company moved out of FDC's offices.  The service contracts could be canceled only upon a 180-day notice, which meant that the startups had to pay for an additional six month period.  Unsurprisingly, these ongoing payments reduced the chance of the startups to succeed, as they were quickly running out of cash.  Overall, there were 24 portfolio companies.  As of 2018, only several remained active.

ERAs Must File with the SEC 

According to Section 202(a)(11) of the Advisers Act, an "investment adviser" is any person that (1) for compensation (2) is engaged in the business of (3) providing advice (4) as to the value of securities or advisability of investing in, purchasing, or selling securities.  The Advisers Act mandates that all investment advisers must register with the SEC, unless exempt or prohibited to do so.  

A fund adviser may be exempt from registering with the SEC if it is an adviser solely to private funds with total AUM under $150 million and that are (i) venture capital funds (Section 203(l) of the Advisers Act) or private funds relying on Section 3(c)(1) or 3(c)(7) exemption under the Investment Company Act (Section 203(m) of the Advisers Act).  Such fund managers must still file Form ADV with the SEC, but a shorter version.

There is also a duty to file annual updates of the Form ADV.  Frost Management Company failed to renew its ERA filing in 2018 and onwards.

In conclusion, this case reminds us that the SEC has jurisdiction over all investment advisers, including the ERAs and the unregistered advisers.  Being an investment adviser, registered or not, big or small, carries the fiduciary duty of good faith and full and fair disclosure that should not be taken lightly.  

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Friday, August 2, 2019

How Using the Word "MAY" Instead of "WAS" Can Cost You $100 Million

On July 24, 2019, the SEC charged Facebook Inc. $100 million for inaccurately disclosing the risk of misuse of user data.  Facebook agreed to pay, without admitting or denying any wrongdoing.  So, what happened?

According to the SEC complaint, the Facebook public filings (such as the annual reports on Form 10-K or the quarterly reports on Form 10-Q, etc.) informed the public that "our users' data MAY be improperly accessed, used or disclosed" (emphasis added), but in fact, at that time Facebook already knew that it was true.  It all goes back to the infamous Cambridge Analytica scandal (CA paid an academic to collect and transfer from Facebook certain data in violation of the Facebook policies).  Later, CA used such data for clients' political campaigns.  According to the SEC complaint, Facebook discovered the misuse by December 2015 but failed to correct its public company disclosure until May 2018.

This was a material risk, and in Facebook's case, it became a reality.  However, the company did not move it from the category of "possible risks" to the category of "real events".  Rule 10b-5 under the Securities Exchange Act (like Section 17(a)(2) of the Securities Act which is near identical) prohibits companies to make "any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading...".  Most securities lawyers know this phrase verbatim.   Perhaps, there was a question of whether such information was "material" to Facebook's stockholders (there are ongoing debates about the materiality standard, although in this case misusing data of 30 million Facebook users does sound "material").  Perhaps, Facebook management did not actually know about what was happening or was in disbelief.  Perhaps, some people knew but failed to communicate it to others with the disclosure-making responsibilities.  Whatever the explanation is, the fact remains that after Facebook finally publically announced that it knew about the data breach, its share price dropped, underscoring the importance of this information.  Well, this turned out to be a costly misuse of the three letters MAY. 

Drafting disclosure documents is not creative writing.  This skill is rooted in the deep understanding of the legal standards, the industry, the company, and the specific risks the company faces.  It is also based on the information that is being made available to the drafter.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.